The Budget and beyond

It has been a frenetic first month for the new government. But amidst the flurry of events, the contours of economic policy are slowly becoming clear. There is an unmistakable emphasis on supply-led measures to boost investment.

Among these, the accent would be on structural steps which lie outside of the Budget — such as lowering the cost of land and labour so that the rising cost of capital in a high-inflation economy is negated.

A preference for supply-led, structural measures arises from the belief that they have a long-term impact, and that a government with a strong political mandate is best placed to carry them out. However, there could be a push for supply-led moves even in the short run – in other words, in the Budget.

What is this push all about? It is believed by some that a demand side approach may raise inflation and wages, thereby further depressing industrial and agricultural output. Which, of course, prompts the question: If wages remain so depressed as to pull down overall demand, can it pull down investment and output all the more?

The UPA had economists of both hues, the ‘supply’ camp represented by the Prime Minister and the ‘demand’ camp by the National Advisory Council. The present government is more unambiguous. Global investors favour a supply-driven approach to reviving growth, one where the Government acts as facilitator rather than direct investor. Hence, the slogan of ‘minimum government, maximum governance’ resonates well with them. They have lifted the Sensex to record highs. If his initial statements are any indication, the finance minister may go for a mix of muted demand stimulus and forceful supply-easing steps. In fact, supply side steps are calculated to attract foreign investment, which can lift the rupee and lower the cost of imports. This was the UPA’s approach, by and large: trying to manage the exchange rate through the capital account.

Capital flows are, however, beyond the Government’s control. The exchange rate and interest rate will always work as supply constraints. The task is to make investment happen, nevertheless.

In trying to crank up the economy, the Budget could also run up against a monsoon constraint. The Government would perhaps have liked to hold back spending in welfare schemes such as the MGNREGS to keep the floor wage of the economy in check. But if a weak monsoon translates into lower demand for workers, it would be hard to cut back safety net schemes. A trapeze act lies in store: Will the Government please producers or unorganised sector workers?

A combination of tax breaks to producers in the forthcoming Budget and (the promise of) structural moves in later months could ease up the supply side. But that still may not boost investment if demand remains sluggish in a high-inflation and high unemployment scenario.

The Budget may, therefore, peg the fiscal deficit at 4.5 per cent of GDP, against the Interim Budget’s target of 4.1 per cent, by raising public spending in infrastructure through PPPs.

Other demand-raising moves seem hard to pull off. Will the Budget, for instance, award tax breaks to individuals when prices are under pressure? The finance minister may think twice, unless he is persuaded that inflation is basically a supply-side problem. However, even if he does so, consumption may not increase at a time of uncertain employment prospects. Any diversion of disposable income towards savings may not raise overall savings if unemployment increases. For similar reasons, incentives such as Section 80C to boost savings may not lift overall savings. However, it could lower demand and, therefore, worsen prospects of an investment revival. Therefore, excise breaks to boost investment and production seem like a better bet.

Yet, the Government could feel politically impelled to reward the salaried class which played no small role in bringing it to power. The move may be pushed as a ‘sentiment booster’ for the economy with uncertain effects.

There is another area where the Government will have to take a call if it is to revive growth: curb the perverse incentives that push capital into asset classes rather than production of actual goods. The mismatch between a booming Sensex and a sluggish economy has time and again come to the fore. Both the Budget and monetary policy should look at rebalancing incentives.

It seems the Government is keen on increasing and diversifying the funds flow into equities, and may focus on tapping individual investors’ savings in insurance, pension and provident funds. However, there is a place for long-term, institutional lending, driven by public sector financial institutions as opposed to fund managers whose ‘long term’ horizon is not all that long.

So, from the looks of it, if we are looking for fresh perspectives in the Budget, we may be disappointed. What we are seeing is the UPA vehicle being driven by a more purposeful driver!

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